April 2011

 “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness…”   Charles Dickens, A Tale of Two Cities.

4-1-2011, The above quote clearly articulates the different paths that private industry and government are presently on. 
The private sector is emerging from the recession. It’s growing, adapting, and succeeding. Meanwhile, the government sector is being forced to shrink, confused about what to do, and in many countries, literally failing. 
And predictably, if you watch the news every night, you receive only the bad-news side of the story. Good news rarely makes the nightlies or dailies. 
So, where is the balance? What is really happening? Let’s take a step back and review.
After a healthy rebound in equities in 2009-2010, many now believe the “run must be over.” After all, unemployment is still high, government debts and deficits are soaring, the housing sector is still weak, Japan is coping with tragedy, and Gaddafi just won’t leave.
With this as backdrop, we remain contrarian to this negative thinking about 2011’s prospects. At these levels, we still see solid values in many stocks…. not so solid values in long-dated corporate bonds…and high-risk-low-reward ratios in government and municipal bonds.
To understand our perspective, we need to take you back to early 2007 and recall the “lay of the land.” For corporations, times were “okay,” but pressures were building. The markets were fine, but there was concern about underlying trends.
I remember being at an ACLI (American Council of Life Insurers) Roundtable meeting in January of 2007. There, Goldman Sachs economist, Jan Hatzius, presented a very gloomy outlook regarding mortgage foreclosures.   He noted that the default rate for sub-prime loans made less than 90 days previous was over 300 basis points (3%).
How could you have 3% of long-term loans go bad in only 3 months? It was the canary in the coal mine.
And while 3% doesn’t seem earth changing, it was certainly concerning for all those CEOs with sub-prime investments on their balance sheets. We all hoped it would be short -term. Clearly, it was not! It all fell apart later that year---and totally melted down as we headed into 2008. Banks were wiped out, and credit disappeared. 
While corporate balance sheets deteriorated, access to credit lines evaporated. Workers were laid-off or took substantial pay cuts.    Benefits were cut. Costs were squeezed at all levels. Every ounce of excess was taken out of the inventory and supply chains.
It was the worst of times for the private sector.
Meanwhile, the government (not-for-profit) sector was booming. Governments at all levels were aggressively hiring. State and federal unions were winning negotiated raises and benefits. 
Universities were raising tuitions, increasing cost structures, and growing student count---all heavily funded by State and Federal programs. Hospitals and healthcare providers were expanding on an ocean of government largess. There seemed no end to the populism of more entitlements.
It was the best of times for the government sector.
By 2009, however, something remarkable was happening. The private sector began to show “green shoots” while all at once the “bloom was falling off the rose” in the government sector--- and at all levels, city, state, and federal.
How the private sector and public sector could be so out-of-step with each other understandably confused the markets for a time. This seemed to mute the rebound as we climbed out of a severe recession.   But, as reality began to sink in, rising quarterly earnings confirmed the trend.
By 2010, the facts were undeniable…things were getting better on the private side and deteriorating on the public side. The country (and to a great extent, many other countries) awoke to realize we had overshot the build-up of government.
Stocks rebounded while governments staggered.
And that brings us to 2011. Corporate balance sheets are relatively strong. Cost structures are aligned with revenue streams. The world economy is still growing and there remains an increasing need for quality products everywhere. We are, once again, in a growth mode.
But, it doesn’t “feel” like we are, does it?
We believe this is because of the constant drumbeat of bad news coming out of governments…all of which is true, but only tells half the story. 
You see, while government jobs are being lost, private jobs are being added. That may not change the overall unemployment rate, but it is a trade to a healthier economy. 
We believe there is still pain to come as we “right size” government; but those who cannot see how the government and private sectors have decoupled will miss opportunity. That does not mean, however, that every stock will benefit.
Companies that rely heavily on government contracts for their revenues will likely suffer—for example, many healthcare and education firms will be stressed. We believe, however, that those non-government centric firms that did things right in 2007-2009 will continue to prosper into 2011 and 2012.
This is why we are looking past the negative news connected to the public sectors. 
Beginning in August 2010, we significantly reduced our investment exposure connected to the government sector…meaning we sold municipal bonds, hospital stocks, and stocks overly dependent on government contracts. We then rotated that capital into companies with solid balance sheets, great management teams, international reach, & those selling “must have” products or services. 
It is not easy for investors to think past the headlines we hear every day. It is even harder to go “risk-on” behind your convictions. Looking back, we have been rewarded by independent thinking and action. 
Looking forward….we will see.


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